Quick Ratio: Definition, Formula, and Examples
The quick ratio measures a company’s ability to pay for its current liabilities with its most liquid, short-term assets.
What Is the Quick Ratio?
The quick ratio is a conservative measure of a company’s liquidity. It is used to determine a company’s ability to pay for its short-term obligations with its most liquid assets. These liquid assets include cash, cash equivalents, marketable securities, and accounts receivable. These are considered “quick” assets as they are highly liquid. Liquidity is defined as how easily something can be converted into cash.
The quick ratio is often depicted as a number. For example, a quick ratio of 1.0 would indicate the company has exactly the amount of liquid assets necessary to pay its current liabilities. A quick ratio of less than 1 means the company does not have the necessary liquid assets to cover its current liabilities, and a quick ratio of greater than one indicates it has more than enough liquid assets to cover its debts as they come due.
What Is the Quick Ratio Formula?
There are several versions of the quick ratio formula, but they all include the same components. It’s just a matter of how those components are presented. Below are the most common quick ratio formulas.
In its simplest form, we have the following formula:
Quick Ratio = Liquid Assets / Current Liabilities
A slightly more detailed version of the quick ratio formula is the following:
Quick Ratio = (Current Assets - Inventory - Prepaid Expenses) / Current Liabilities
Finally, the most detailed quick ratio formula is the following:
Quick Ratio = (Cash and Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
What Are The Components of the Quick Ratio?
The goal of the quick ratio formula is to measure a company’s ability to pay its current liabilities with its most liquid, short-term assets. The quick ratio formula uses current assets– less inventory and prepaid expenses– and current liabilities. Here are the components of the quick ratio:
- Cash
- Cash Equivalents
- Marketable Securities
- Accounts Receivable
- Current Liabilities
What is Cash?
Cash is the simplest component of the quick ratio. It’s the balance the company has in all its cash accounts from the general ledger. It may include petty cash –cash on hand– and cash in various bank accounts. Cash in bank accounts should be reconciled to the general ledger on a monthly basis, at a minimum.
What are Cash Equivalents?
Cash equivalents are highly liquid investments that can be converted to cash quickly, have a low risk of value fluctuations, and have an original maturity date of three months or less. For example, a Certificate of Deposit or a U.S. Treasury bill with a maturity date of three months or less, upon acquisition by the company, qualifies as a cash equivalent.
What are Marketable Securities?
Marketable securities are financial instruments that are actively traded, have an identifiable value, and can be readily converted to cash. Marketable securities can be either equity or debt securities. Equity securities are investments in a company that allow the investor partial ownership of the company. Examples include common or preferred stock. Debt securities offer a guaranteed interest payment in exchange for borrowed money. Examples include bonds and treasury bills.
What is Accounts Receivable?
Accounts receivable include amounts that the company expects to receive from customers who have made a purchase on credit. Because accounts receivable are short-term in nature, it is included in liquid assets. Be sure to only include net accounts receivable, which subtracts an allowance for doubtful accounts or allowance for bad debts from the total the company is owed by its customers. Net accounts receivable is the total the company expects to actually receive.
What are Current Liabilities?
Current liabilities are a company’s short-term debt obligations, typically due within the next year. It includes accounts payable, short-term loans, and the current portion of long-term debt. Companies need to have sufficient liquidity to pay these current liabilities as they come due.
What Is the Difference Between Quick Ratio and Current Ratio?
The quick ratio divides highly liquid assets by current liabilities, while the current ratio divides current assets by current liabilities. Not all current assets would be regarded as highly liquid. For example, inventory, and prepaid expenses would not qualify as highly liquid assets.
The quick ratio is much more conservative than the current ratio– which does not remove inventory or prepaid expenses from its formula. The formula for the current ratio is:
Current Ratio = Current Assets / Current Liabilities
The quick ratio removes inventory and prepaid expenses because, although they are both current assets, they can not be quickly and easily converted to cash. Inventory is excluded because it cannot be quickly converted to cash and the dollar amount is not certain. If a company is in a hurry to convert its inventory into cash, it may have to offer steep discounts which decrease the potential cash value of the inventory compared to the book value. Prepaid expenses are excluded because they likely cannot be refunded in the short term in order to cover the company’s current liabilities.
What Are the Pros and Cons of the Quick Ratio?
The quick ratio is a conservative measure of a company’s true liquidity and ability to pay its bills in the short term. It is easy to measure, as all of the components can be readily identified on a company’s balance sheet. It allows a potential investor or lender to compare the company to other companies in the same industry. It can also help to track the company’s performance over time.
While the quick ratio provides a great indicator of a company’s current and past liquidity, it does not provide any insight into the company’s future liquidity. The quick ratio does not take into account any activity that the business has planned in the near future but the impact has not hit the balance sheet yet.
Example of Quick Ratio
Suppose we have ABC Company and XYZ Company. Both have calculated their quick ratios with the components available to them on their balance sheets.
The ratios for both companies can be calculated as follows:
ABC Company’s Quick Ratio = ($500,000 + $100,000 + $50,000) / $650,000 = 1.00
Where:
- $500,000 = Cash and Cash Equivalents
- $100,000 = Marketable Securities
- $50,000 = Accounts Receivables
- $650,000 = Current Liabilities
XYZ Company’s Quick Ratio = ($700,000 + $50,000 + $25,000) / $675,000 = 1.15
Where:
- $700,000 = Cash and Cash Equivalents
- $50,000 = Marketable Securities
- $25,000 = Accounts Receivables
- $675,000 = Current Liabilities
Based on this calculation, XYZ company has a better quick ratio, meaning they are more likely to cover their short-term obligations when they are due. For ABC company, having a quick ratio of 1 means they only have the exact amount of liquid assets to cover current liabilities. This puts ABC company at an uncertain position.
Real Company Example: Macy’s Quick Ratio
The quick ratio is easy to calculate using the highlighted figures from the balance sheet in Macy’s 2022 Annual Report, for the fiscal year ending January 28, 2023.
As of January 28, 2023, Macy’s had cash and cash equivalents of $862 million, receivables of $300 million, and total current liabilities of $4.861 billion.
Macy’s Quick Ratio in Jan 2023 = ($862 million + $300 million) / $4.861 billion = 0.24
As of January 29, 2022, Macy’s had cash and cash equivalents of $1.712 billion, receivables of $297 million, and total current liabilities of $5.416 billion.
Macy’s Quick Ratio in Jan 2022 = ($1.712 billion + $297 million) / $5.416 billion = 0.37
This tells us that Macy’s quick ratio has decreased over the year, and it indicates a decrease in their ability to cover their debt obligations as they come due. However, Macy’s is an interesting case as a major retail store because most of their current assets are tied up in merchandise inventory– $4.267 billion in 2023 and $4.383 billion in 2022 to be exact. Using the current ratio, the numbers would look much better.
Macy’s Current Ratio in Jan 2023 = $5.853 billion current assets / $4.861 billion = 1.20
Macy’s Current Ratio in Jan 2022 = $6.758 billion current assets / $5.416 billion = 1.25
As seen in the example above, it is important to consider not just the quick ratio, but also other relevant ratios such as the current ratio when assessing a company’s liquidity.
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